The Basics of Captives

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1 The Basics of Captives Extended Warranty & Service Contract Innovations September 18, 2013 Belinda Fortman Regional Manager Strategic Risk Solutions t: e: Derick White President SRS Vermont t: e: 1

2 Discussion Points Captive 101 Definition Types Uses Captive Case Studies / Examples Key Considerations to Successful Captives Q&A 2

3 Captive 101

4 Captive 101 Definition: A closely held insurance company that is owned and controlled primarily by its insureds Characteristics A licensed insurance company Formed to insure or reinsure the risks of its owners or related parties of their choosing Regulated under special legislation regulating captives Located onshore or offshore Generally licensed in only one domicile

5 Types of Captives Single Parent (Pure) Captive Wholly owned by one parent company Formed primarily to insure or reinsure the risks of the corporate parent or unrelated parties of their choosing Group Captive Owned by two or more companies, often times affiliated through a trade association or homogenous group of companies Heterogeneous group captives are also available Formed to insure or reinsure the risks of the group 5

6 Types of Group Captives Group Captive Types Association for members of the association Industry Insured (Group) owned by insureds within a given industry of a certain size Risk Retention Group (RRG) - liability-only insurance company that is owned by its members and can function as an admitted carrier under U.S. Liability Risk Retention Act (LRRA) Domiciles now provide increased flexibility for structures that do not fit neatly into the established categories through the use of special purpose captive provision. 6

7 Risk Management Framework Risk Transfer Catastrophic Losses Low Frequency Manageable Losses Less Frequency Risk Sharing Risk Retention High Frequency Low Severity 7

8 Captive Risk Uses Workers Compensation Employment Practices Liability Product & Professional Liability General Liability Auto Liability All Risk Property/Cargo Windstorm 8

9 Captive Risk Uses Property & Casualty Risks - Deductibles (Product Liability, Workers Compensation, Auto Liability, etc.) Catastrophic Risks (Traditional and Non-Traditional) Employee Benefits (US and ex-us) Medical Stop Loss Third-Party Risks Extended Warranty Franchisee Risks Vendor or other Controlled Risks Almost Any Risk - Coverage which is unavailable or expensive can be insured through a captive, such as cyber risk, intellectual property risk or credit risk 9

10 Captive Risk Placement Structures Reinsurance Paid-In Capital ABC Company Premium/ Policy Front Company Reinsurance Premium ABC Pure Captive Program Assets/ Liabilities LOC/Reinsurance Trust Structured Collateral A B C Direct/RRG Paid-In Capital ABC Company Premium/ Policy ABC Pure Captive/ RRG 10

11 Group Captive Structure Paid-In Capital M Policy Issuing Carrier E M B E Program Premium Front Company Reinsurance Premium Group Captive R S 11

12 Risk Retention Group Structure M E Paid-In Capital M B E Program Premium Risk Retention Group Reinsurance, If any Third Party Reinsurance R S 12

13 Why a Captive? The main reason captives are formed is to increase the level of control over all facets of insurance. Increased control over: Ultimate Cost; Reduced cost/increased tax efficiency; Coverage breadth; Claims Handling; Loss Control; and Embedded Insurance Program Profit. Complete insulation/separation from the commercial insurance market is challenging due to capital requirements. 13

14 Where Are Captives Formed? Domicile 2012 Active Licenses (per BI) Bermuda 856 Cayman Islands 741 Vermont 586 Guernsey 333 Anguilla 291 Other Onshore Domiciles Utah 287 Delaware 190 Hawaii 179 Washington DC 170 South Carolina 149 Tennessee 9 14

15 Key Domicile Decision Factors Regulator Experience Regulator Accessibility Regulatory Flexibility willingness to listen and work collaboratively Frictional Cost Capital Requirements Physical Accessibility Eliminate Perception Issues 15

16 Captive Case Studies/Examples

17 Deductible Buy Down Captive allows owner to buy down retentions Manage subsidiary risk exposure Establish deductible reserves within existing SIR Current Excess Program Current Excess Program Current Retention 17 Captive Layer Revised Retention

18 Direct Access to Reinsurance Market arbitrage opportunity on professional liability Access capacity via reinsurance Prevalent in medical malpractice insurance Group unbundles and controls each insurance activity Doctor Group Premium 100% Transfer Commercial Market Doctor Group Premium 100% Transfer Risk Retention Group Reinsurance Reinsurance Company 18

19 Manage Program Costs Captive retains liability quota share participation to maintain structure pricing Captive can then access reinsurance or retain 100% of the risk based on market fluctuations Captive Market F Market D Market E Market A Market B Market C Retained Risk 19

20 Profit Center Captive Self storage company marketed insurance to its customers Property coverage with loss ratio of less than 40% Inserted captive into transaction to share in the underwriting profit generated by their core business Self-Storage Customers Premium 100% Transfer Commercial Market Self-Storage Customers Premium 100% Transfer Commercial Market Quota-share Reinsurance Self-Storage Captive Insurance Company 20

21 Medical Stop-Loss Captive allows owner to insure buffer layer risk Procure excess at optimal price point Access reinsurance for aggregate protection Current Stop-Loss Program Current Retention Revised Stop-Loss Program Captive Layer Current Retention 21

22 Vehicle Service Contracts Auto/Equipment dealers selling service contracts to customers Service Administrator is required to have back up commercial insurance Service Administrator utilizes captive Captive Insurer $500 premium Record $500 profit now $1,000 revenue $300 expected costs Service Administrator Admin Equipment Dealer Service Contract Equipment Buyer 22

23 Captive Caveats/ Key Considerations

24 Captive Caveats 1. Captives require capital to begin underwriting - $120,000 - $250,000 base capital plus risk capital depending upon volatility of the underlying risk being insured. 2. Captives have annual operating costs of between $60,000 and $150,000 or higher for management, audit, actuarial certification and regulatory fees with ultimate cost a function of the underlying program complexity and domicile location. 3. Captives require a specific fact pattern to achieve insurance company tax treatment. 24

25 Tax Structure Requirements Underwriting Risk Transfer Must be risk of loss to insurance company Risk Shifting and Distribution transfer of risk from many insured to adequately capitalized insurer - law of large numbers Commonly accepted notion of insurance transaction must function like real insurance limited loan backs, retro provisions, payback provisions, timely payment of premium, claim processing Non-tax business purpose 25

26 Keys to Successful Captives

27 Keys to Successful Captives Sense of urgency problem to solve or clearly defined objective Properly funded relative to risk profile Focus on loss control and claims management Long-term commitment - discipline to stay the course through markets cycles Strong business partners captive manager, claims service, actuary, banking and investment advisors 27

28 Keys to Successful Captives Clear understanding of the benefits and operational challenges Trust and transparency if sharing risk with other parties Operational efficiency 28

29 QUESTIONS & ANSWERS 29

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